Surging Asian inflation could hit Western markets

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While Western investors are preoccupied with ongoing discussions about escalating financial woes, a recessionary US economy and rising inflation, the consequences of surging Asian inflation have received relatively little coverage.

The upshot of rapidly rising inflation in Asia could not only result in stronger Asian currencies, but also in reduced Asian investment in Western bond markets and, over the longer term, the need for higher real rates in the West with commensurate implications for lower economic activity.

This scenario was very succinctly argued in a recent research report by Pierre Gave of investment house GaveKal. His views are repeated below.

For the past year, we have warned that rising inflationary pressures in Asia could trigger a change in Asian monetary policy. The idea was fairly simple: If Asian inflation continued to creep up, then Asian policymakers would have little choice but to let their currencies appreciate. And in so doing, they would no longer be forced buyers of US and EMU bonds. This would be especially likely if food inflation took off, since the tolerance for rising food prices is very low in the emerging markets of Asia.

We first saw this unfold in India: Frustrated by the inability of conventional tightening measures to combat inflation, Indian policymakers decided to let the currency appreciate. In the second and third quarters of 2007, the Indian rupee was one of the best-performing currencies in the world, gaining 11% against the US$. As a result, Indian inflation fell from 6.7% to 3.0% in just eight months. At the time, the question was whether inflation would spread to the rest of Asia – and, if so, how other Asian policy makers would react.

Recent months have provided a clear answer to that question: Asian inflation is undoubtedly on the rise. China recorded a 7.1% year-on-year gain in consumer prices in January, the highest inflation rate since September 1996. In Singapore, CPI growth accelerated to 6.6% year on year in January, the fastest pace since 1982 … In fact, wherever you care to look, prices in Asia are clearly moving higher, mostly because of a massive rally in soft commodities.

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With the above in mind, we should not be surprised to see Asian currencies rise more aggressively in the near future. For example, the market has now massively adjusted its expectations of future Chinese renminbi appreciation.

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Given the rising inflationary pressures, we fully expect Asian currencies to appreciate at a faster rate. And as this happens, Asian central banks (followed by Asia’s private savers) will export less capital into the bond markets of the West. This will mean higher real rates in the West, as well as a collapse in monetary aggregates. In turn, this will most likely trigger a big drop in economic activity.

Of immediate consequence: be very careful of overvalued US and EMU government bonds.

Source: Pierre Gave, GaveKal – Ad Hoc Comment, February 29, 2008.

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6 comments to Surging Asian inflation could hit Western markets

  • Douglas Russell

    >

    This seems contrary to my experience. Where inflation has run rampant I have observed currencies loosing strength. Check out Zambia/Zaire. Which was cause and which was effect is arguable. But I can not think of an inflation riddled economy which has resulted in that currency getting stronger.

    Can you?

  • Jaime

    I enjoy all the things you choose to post. It strikes me as good information and you postings are timely. Thank you for your generosity in doing it.

  • South Africa’s inflation rate accelerated in January too reaching its highest in almost five years………more rate hikes coming to benefit the rand carry trade.

    Successful Trading Tips.com

  • The comments about the Indian economy are correct. The finance ministry has allowed the Rupee to appreciate as the inflow of huge amounts of dollars was a concern. This has had an impact on inflation especially the crude basket which the government buys for the local demand. Also interest rates were increased by the Reserve Bank to keep inflation in check.

  • Frank Wordick

    China had inflation in the food sector of 18% in 2007. The government is worried about rioting, because the Chinese peasant is very sensitive to rising food costs. What Douglas Russell states is in my opinion not untrue. However, the sort of inflation he is talking about is I believe internally induced, e.g. by running the government printing press. Where inflation is imported, that is where it is caused by a large currency influx, it will cause the currency to rise as the law of supply and demand stipulates. Where the currency is pegged in some way, the currency will not rise enough to counter the inflation, which will be produced. However, if the government unpegs it, the currency will indeed rise and do its duty. I wonder how much effect this will have on the US bond market, which is huge. One must also recall that the stock market appears to be headed downhill. Investors usually head for the AAA-bond market to find a hiding place. There have been numerous warnings about bond overpricing, but bond yields go lower and lower as the stock market heads lower and lower.

  • Dan Modricker

    To counter the double-digit inflation I see coming (just like the ’70s), I went from cash into energy, TIPs (inflation protected securites) and convertible securities.

    The only thing I had to unwind (on 2/28) was a PA Tax-exempt muni fund … since I’ve been sitting on the sideline the past two years; waiting for the US equity markets to “get real”.

    I haven’t touched my international growth fund since I bought it in 1963. I was confident that I shouldn’t have all my assets denominated in US dollars; since at that time the US was running a 10-12 Million (not Billion) per year trade account deficit (and it was edging upward).
    By the time we became a net “debtor” nation, I was convinced that my 1963 decision was correct.

    John Mauldin’s weekly financial e-letter gave me exactly the right advice to weather the “tech-stock bubble burst” in 2001. So all-in-all, I can’t complain about my consistently positive returns the past 45 years.

    It really pays to know when to hold them, and when to fold them, and when to be in equities, bonds (debt) and cash. The trickiest time (for me) is during stagflation.

    Just as Asia has been exporting deflation to us the past 10 years (ever since multinational corporations based in the US started outsourcing in earnest), I fully expect that Asia will now export inflation to us for the next 10+ years
    … or until we get back some of those jobs we outsourced.

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